Chapter 3

Decision Analysis
(cont)

2008 Prentice-Hall, Inc.

 Decision Trees
Any problem that can be presented in a decision
table can also be graphically represented in a
decision tree
Decision trees are most beneficial when a sequence
of decisions must be made
All decision trees contain decision points or nodes
and state-of-nature points or nodes

2009 Prentice-Hall, Inc. 32

 Structure of Decision Trees
Trees start from left to right
Represent decisions and outcomes in
sequential order
Squares represent decision nodes
Circles represent states of nature nodes
Lines or branches connect the decisions
nodes and the states of nature

2009 Prentice-Hall, Inc. 33

 Five Steps to
Decision Tree Analysis

1. Define the problem

2. Structure or draw the decision tree
3. Assign probabilities to the states of
nature
4. Estimate payoffs for each possible
combination of alternatives and states of
nature
5. Solve the problem by computing
expected monetary values (EMVs) for
each state of nature node

2009 Prentice-Hall, Inc. 34

 Thompson Lumber Company

STATE OF NATURE

FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 180,000

Construct a small plant 100,000 20,000

Do nothing 0 0

Table 3.1

2009 Prentice-Hall, Inc. 35

 Thompsons Decision Tree
A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
s tr la
o n eP
C arg
L Favorable Market
Construct
Small Plant 2
Unfavorable Market
Do
No
th
in
g
Figure 3.2

2009 Prentice-Hall, Inc. 36

Identifying the best decision in the tree

Work from right to left

Calculate the expected payoff at

each outcome node

Choose the best alternative at each

decision node (based on expected
payoff)

2009 Prentice-Hall, Inc. 37

 Thompsons Decision Tree
EMV for Node = (0.5)($200,000) + (0.5)($180,000)
1 = $10,000 Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EMV is selected 1
Unfavorable Market (0.5)
ct nt
$180,000
u
tr la
s
n eP
o
C arg
L Favorable Market (0.5)
$100,000
Construct
Small Plant 2
Unfavorable Market (0.5)
$20,000
Do
No
th EMV for Node = (0.5)($100,000)
in
g 2 = $40,000 + (0.5)($20,000)
Figure 3.3
$0
2009 Prentice-Hall, Inc. 38
 Thompsons Complex Decision Tree
Thompson Lumber Co. consider the decision to make a
survey about the market before making the decision to build
the new plant.
With their experience, they know that the result of this survey can be
positive with 45% or negative with 55%.
The cost of this survey is $10,000
Second Decision
Point

)
First Decision y (0.45
Point Surve
lts
y 1 Resu able
Su rve Favor
ket Su
ct Ma r Re rvey (
Co ndu Ne sults 0 .5
5)
ga
tiv
e

Do No
t Condu
ct S urvey

2009 Prentice-Hall, Inc. 39

 Thompsons Complex Decision Tree
If the survey leads to positive result (45%), the conditional probability
for occurrence of each state of nature is:
Favorable market: 78%
Unfavorable market: 22%
If the survey leads to negative result (55%), the conditional probability for
occurrence of each state of nature is:
Favorable market: 27%
Unfavorable market: 73%
If Thompson Lumber Co. decides not to conduct the survey, the
probability for each state of nature is same, 50% for favorable market and
50% for unfavorable market

2009 Prentice-Hall, Inc. 3 10

 Thompsons Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
Favorable Market (0.78)
$190,000
nt 2 Unfavorable Market (0.22)
ePla $190,000
g
Lar Favorable Market (0.78)
$90,000
) Small
. 45 Plant
3 Unfavorable Market (0.22)
$30,000
(0
e y ts e
rv ul abl No Plant
$10,000
Su Res vor
1 Sur Fa Favorable Market (0.27)
ve $190,000
ey

Re y ( nt 4 Unfavorable Market (0.73)

rv

Ne su 0.5 Pla $190,000

Su

5) g e
ga lts Lar Favorable Market (0.27)
$90,000
t

tiv Small
ke

e 5 Unfavorable Market (0.73)

ar

Plant $30,000
tM
uc

No Plant
$10,000
nd
Co

Do Favorable Market (0.50)

Not $200,000
Con nt 6 Unfavorable Market (0.50)
duc Pla $180,000
tS ge
urv Lar Favorable Market (0.50)
$100,000
e y Small
Plant
7 Unfavorable Market (0.50)
$20,000
No Plant
$0
Figure 3.4
2009 Prentice-Hall, Inc. 3 11
 Thompsons Complex Decision Tree

1. Given favorable survey results,

EMV(node 2) = EMV(large plant | positive survey)
= (0.78)($190,000) + (0.22)($190,000) = $106,400
EMV(node 3) = EMV(small plant | positive survey)
= (0.78)($90,000) + (0.22)($30,000) = $63,600
EMV for no plant = $10,000
2. Given negative survey results,
EMV(node 4) = EMV(large plant | negative survey)
= (0.27)($190,000) + (0.73)($190,000) = $87,400
EMV(node 5) = EMV(small plant | negative survey)
= (0.27)($90,000) + (0.73)($30,000) = $2,400
EMV for no plant = $10,000

2009 Prentice-Hall, Inc. 3 12

 Thompsons Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
la nt Unfavorable Market (0.22)

$106,400
P $190,000
a rge $63,600 Favorable Market (0.78)
L $90,000
) Small
45 Unfavorable Market (0.22)
. Plant $30,000
(0
e y ts e
rv ul abl No Plant
$10,000
Su Res vor
Su Fa $87,400 Favorable Market (0.27)
rv $190,000
ey

e
Re y ( nt Unfavorable Market (0.73)
rv

Ne su 0.5 Pla $190,000

Su

5) rge $2,400
$2,400
ga lts La Favorable Market (0.27)
$90,000
t

tiv Small
ke

e Unfavorable Market (0.73)

ar

Plant $30,000
tM
uc

No Plant
$10,000
nd
Co

Do Favorable Market (0.50)

Not $200,000
Con nt Unfavorable Market (0.50)
duc Pla $180,000
tS ge
urv Lar Favorable Market (0.50)
$100,000
e y Small
Unfavorable Market (0.50)
Plant $20,000
No Plant
$0
Figure 3.4
2009 Prentice-Hall, Inc. 3 13
 Thompsons Complex Decision Tree

3. Compute the expected value of the market su

EMV(node 1) = EMV(conduct survey)
= (0.45)($106,400) + (0.55)($2,400)
= $47,880 + $1,320 = $49,200
4. If the market survey is not conducted,
EMV(node 6) = EMV(large plant)
= (0.50)($200,000) + (0.50)($180,000) = $10,000
EMV(node 7) = EMV(small plant)
= (0.50)($100,000) + (0.50)($20,000) = $40,000
EMV for no plant = $0
5. Best choice is to seek marketing information

2009 Prentice-Hall, Inc. 3 14

 Thompsons Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
la nt Unfavorable Market (0.22)

$106,400
P $190,000
a rge $63,600 Favorable Market (0.78)
L $90,000
) Small
45 Unfavorable Market (0.22)
. Plant $30,000
(0
e y ts e
v l l No Plant
S ur esu rab $10,000
$49,200 S R avo
ur F $87,400 Favorable Market (0.27)
ve $190,000
ey

Re y ( nt Unfavorable Market (0.73)

rv

Ne su 0.5 Pla $190,000

Su

5) rge $2,400
$2,400
ga lts La Favorable Market (0.27)
$90,000
t

tiv Small
ke

e Unfavorable Market (0.73)

ar

Plant $30,000
tM
uc

No Plant
$10,000
nd
$49,200
Co

Do $10,000 Favorable Market (0.50)

Not $200,000
Con t Unfavorable Market (0.50)
duc P lan $180,000
ge
$40,000

tS urv Lar $40,000 Favorable Market (0.50)

e y Small $100,000
Unfavorable Market (0.50)
Plant $20,000
No Plant
$0
Figure 3.4
2009 Prentice-Hall, Inc. 3 15
Expected Value of Sample Information

Thompson wants to know the actual value

of doing the survey
Expected value Expected value
with sample of best decision
EVSI = information, assuming
without sample
no cost to gather it information

= (EV with sample information + cost)

(EV without sample information)

EVSI = ($49,200 + $10,000) $40,000 = $19,200

2009 Prentice-Hall, Inc. 3 16

 Sensitivity Analysis

How sensitive are the decisions to

changes in the probabilities?
How sensitive is our decision to the
probability of a favorable survey result?
That is, if the probability of a favorable
result (p = .45) where to change, would we
make the same decision?
How much could it change before we would
make a different decision?

2009 Prentice-Hall, Inc. 3 17

 Sensitivity Analysis
p = probability of a favorable survey
result
(1 p) = probability of a negative survey
result 1) = ($106,400)p +($2,400)(1 p)
EMV(node
= $104,000p + $2,400

We are indifferent when the EMV of node 1 is the

same as the EMV of not conducting the survey,
$40,000

$104,000p + $2,400= $40,000

$104,000p = $37,600
p = $37,600/$104,000 = 0.36
2009 Prentice-Hall, Inc. 3 18
Sensitivity Analysis (cont.)

00
ey , 4
r v $2
su +
g 0p
tin 00
d uc
04,
Co
n $1
V =
EM

Not Conducting Survey

EMV= $40,000

P=0.36

2009 Prentice-Hall, Inc. 3 19

 Bayesian Analysis
Many ways of getting probability data
It can be based on
Managements experience and intuition
Historical data
Computed from other data using Bayes
theorem
Bayes theorem incorporates initial
estimates and information about the
accuracy of the sources
Allows the revision of initial estimates
based on new information
2009 Prentice-Hall, Inc. 3 20
 Calculating Revised Probabilities

In the Thompson Lumber case we used these four

conditional probabilities
P (favorable market(FM) | survey results positive) = 0.78
P (unfavorable market(UM) | survey results positive) = 0.22
P (favorable market(FM) | survey results negative) = 0.27
P (unfavorable market(UM) | survey results negative) = 0.73

The prior probabilities of these markets are

P (FM) = 0.50
P (UM) = 0.50

2009 Prentice-Hall, Inc. 3 21

 Calculating Revised Probabilities
Through discussions with experts Thompson has
learned the following
He can use this information and Bayes theorem
to calculate posterior probabilities
STATE OF NATURE
RESULT OF FAVORABLE MARKET UNFAVORABLE MARKET
SURVEY (FM) (UM)

Positive (predicts P (survey positive | FM) P (survey positive | UM)

favorable market
for product) = 0.70 = 0.20

Negative (predicts
unfavorable P (survey negative | FM) P (survey negative | UM)
market for = 0.30 = 0.80
product)

Table 3.11
2009 Prentice-Hall, Inc. 3 22
 Calculating Revised Probabilities
Recall Bayes theorem is

P ( B | A ) P ( A)
P( A | B)
P ( B | A) P ( A) P ( B | A ) P ( A )

where
A, B any two events
A complement of A

For this example, A will represent a favorable market

and B will represent a positive survey

Thus, A will represent an unfavorable market and B will

represent a negative survey
2009 Prentice-Hall, Inc. 3 23
 Calculating Revised Probabilities
P (FM | survey positive)
P ( survey positive | FM ) P ( FM )

P(survey positive |FM) P(FM) P(survey positive |UM) P(UM)

(0.70)(0.50) 0.35
0.78
(0.70 )(0.50 ) (0.20 )(0.50) 0.45

P (UM | survey positive)

P ( survey positive | UM ) P (UM )

P(survey positive |UM) P(UM) P(survey positive |FM) P(FM)

(0.20)(0.50) 0.10
0.22
(0.20)(0.50) (0.70 )(0.50 ) 0.45

2009 Prentice-Hall, Inc. 3 24

 Calculating Revised Probabilities
Observe the revision in
the prior probabilities
POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF POSITIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY POSITIVE)
FM 0.70 X 0.50 = 0.35 0.35/0.45 = 0.78
UM 0.20 X 0.50 = 0.10 0.10/0.45 = 0.22
P(survey results positive) = 0.45 1.00

Table 3.12

The probability that the state of nature

The Probability that the survey is
shows Favorable market given that
positive and the state of nature
the survey is positive
shows Favorable market.
2009 Prentice-Hall, Inc. 3 25
 Calculating Revised Probabilities
P (FM | survey negative)
P ( survey negative | FM ) P ( FM )

P(survey negative |FM) P(FM) P(survey negative |UM) P(UM)

(0.30)(0.50) 0.15
0.27
(0.30 )(0.50 ) (0.80 )(0.50) 0.55

P (UM | survey negative)

P ( survey negative | UM ) P (UM )

P(survey negative |UM) P(UM) P(survey negative |FM) P(FM)

(0.80)(0.50) 0.40
0.73
(0.80)(0.50) (0.30 )(0.50 ) 0.55

2009 Prentice-Hall, Inc. 3 26

 Calculating Revised Probabilities

POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF NEGATIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY NEGATIVE)
FM 0.30 X 0.50 = 0.15 0.15/0.55 = 0.27
UM 0.80 X 0.50 = 0.40 0.40/0.55 = 0.73
P(survey results positive) = 0.55 1.00

Table 3.13

2009 Prentice-Hall, Inc. 3 27

 Potential Problems Using
Survey Results

We can not always get the necessary

data for analysis
Survey results may be based on cases
where an action was taken
Conditional probability information
may not be as accurate as we would
like

2009 Prentice-Hall, Inc. 3 28

 Utility Theory

Limitations of EMV

Will you accept a 50/50 bet for $5? Probably YES

Will you accept a 50/50 bet for $5m? Probably NO

BUT BOTH HAVE AN EMV = 0!

In some way you care more about losing $5m

than winning $5m

2009 Prentice-Hall, Inc. 3 29

 Utility Theory
You have a lottery ticket with 50% chance to win $5,000,000. And someone
offers $2,000,000 for your ticket.
$2,000,000
Accept
Offer
$0
Heads
(0.5)
Reject
Offer

Tails
(0.5)

EMV = $2,500,000 $5,000,000

Figure 3.6
Do you accept to sell your ticket for $2,000,000?
2009 Prentice-Hall, Inc. 3 30
 Utility Theory
Monetary value is not always a true indicator of the
overall value of the result of a decision
The concept is based on the decision makers
preference to taking a sure payoff versus
participating in a lottery (under risk environment).
The overall value of a decision is called utility

Rational people make decisions to maximize their

utility

2009 Prentice-Hall, Inc. 3 31

 Utility Theory

Utility assessment assigns the worst outcome

a utility of 0, and the best outcome, a utility of 1
A standard gamble is used to determine utility
values
When you are indifferent, the utility values are
equal

2009 Prentice-Hall, Inc. 3 32

 Standard Gamble
(p)
Figure 3.7 Best Outcome
Utility = 1
at i ve1
Altern (1 p) Worst Outcome
Utility = 0
Alte
rn ativ
e2
Other Outcome
Utility = ?

Expected utility of alternative 2 =

Expected utility of alternative 1
Utility of other outcome = (p)
(utility of best outcome, which is 1)
+ (1 p)(utility of the worst
outcome, which is 0)
Utility of other outcome = (p)
(1) + (1 p)(0) = p 2009 Prentice-Hall, Inc. 3 33
 Investment Example
Jane Dickson wants to construct a utility curve
revealing her preference for money between $0
and $10,000
A utility curve plots the utility value versus the
monetary value
An investment in a bank will result in $5,000
An investment in real estate will result in $0 or
$10,000
Unless there is an 80% chance of getting $10,000
from the real estate deal, Jane would prefer to
have her money in the bank
So if p = 0.80, Jane is indifferent between the bank
or the real estate investment
2009 Prentice-Hall, Inc. 3 34
 Investment Example
p = 0.80 $10,000
U($10,000) = 1.0

(1 p) = 0.20 $0
s t in te U($0.00) = 0.0
e
Inv Esta
eal
R
Inv
es
t in
Ba
nk
$5,000
Figure 3.8 U($5,000) = p = 1.0

Utility for $5,000 = U($5,000) = pU($10,000) + (1 p)U($0)

= (0.8)(1) + (0.2)(0) = 0.8
2009 Prentice-Hall, Inc. 3 35
 Investment Example
We can assess other utility values in the same way
For Jane these are

Utility for $7,000 = 0.90

Utility for $3,000 = 0.50

Using the three utilities for different dollar amounts,

she can construct a utility curve

2009 Prentice-Hall, Inc. 3 36

 Utility Curve
1.0
U ($10,000) = 1.0

0.9 U ($7,000) = 0.90

0.8 U ($5,000) = 0.80

0.7

0.6 Janes
0.5 utility curve
U ($3,000) = 0.50
is typical of
Utility

0.4

0.3 a risk
0.2 avoider
0.1

U ($0) = 0
| | | | | | | | | | |
$0 $1,000 $3,000 $5,000 $7,000 $10,000

Monetary Value
Figure 3.9

2009 Prentice-Hall, Inc. 3 37

 Risk Avoiders vs. Risk Takers
A risk avoider will have a concave utility function.
Individuals purchasing insurance exhibit risk
avoidance behavior.
A risk taker, such as a gambler, pays a premium to
obtain risk. His/her utility function is convex. This
reflects the decision makers increasing marginal value
of money.
A risk neutral decision maker has a linear utility
function. In this case, the expected value approach
can be used.
Most individuals are risk avoiders for some amounts of
money, risk neutral for other amounts of money, and
risk takers for still other amounts of money.

2009 Prentice-Hall, Inc. 3 38

 Utility Curve

Risk

er
ak
Avoider

M
on
i
is
ec
D
al
Utility

tr
eu
N
k
is
R

Risk
Seeker

Monetary Outcome
Figure 3.10

2009 Prentice-Hall, Inc. 3 39

 Utility as a
Decision-Making Criteria

Once a utility curve has been developed

it can be used in making decisions
Replace monetary outcomes with utility
values
The expected utility is computed instead
of the EMV

2009 Prentice-Hall, Inc. 3 40

 Utility as a
Decision-Making Criteria

Mark Simkin loves to gamble

He plays a game tossing thumbtacks in
the air
If the thumbtack lands point up, Mark wins
$10,000
If the thumbtack lands point down, Mark
loses $10,000
Should Mark play the game (alternative 1)?

2009 Prentice-Hall, Inc. 3 41

 Utility as a
Decision-Making Criteria
Tack Lands
Point Up (0.45)
$10,000

Tack Lands
1 ame
Point Down (0.55)
ti ve the G $10,000
terna lays
Al rk P
Ma
Alt
e rn
ati
ve
2
Mark Does Not Play the Game
$0
Figure 3.11

2009 Prentice-Hall, Inc. 3 42

 Utility as a
Decision-Making Criteria

Step 1 Define Marks utilities

U ($10,000) = 0.05
U ($0) = 0.15
U ($10,000) = 0.30

Step 2 Replace monetary values with

utility values
E(alternative 1: play the game) = (0.45)(0.30) + (0.55)(0.05)
= 0.135 + 0.027 = 0.162
E(alternative 2: dont play the game) = 0.15

2009 Prentice-Hall, Inc. 3 43

 Utility as a
Decision-Making Criteria
1.00

0.75
Utility

0.50

0.30
0.25

0.15

0.05
| | | | |
0

$20,000 $10,000 $0 $10,000 $20,000

Monetary Outcome Figure 3.12

2009 Prentice-Hall, Inc. 3 44

 Utility as a
Decision-Making Criteria
Tack Lands Utility
Figure 3.13 E = 0.162 Point Up (0.45)
0.30

Tack Lands
1 ame
Point Down (0.55)
t ive the G 0.05
te rna lays
Al rk P
Ma
Alt
e rn
ati
ve
2
Dont Play
0.15

E(alternative 1: play the game) = (0.45)(0.30) + (0.55)(0.05)

= 0.135 + 0.027 = 0.162
E(alternative 2: dont play the game) = 0.15
2009 Prentice-Hall, Inc. 3 45
 Homework 03

Prob. 3.28, 3.29, 3.31, 3.34, 3.36, 3.38, 3.42, 3.45

2009 Prentice-Hall, Inc. 3 46